Corporate Finance

DAVID MCLEAN: Hi, everyone. Welcome to Corporate Finance. My name is David McLean. I'm a professor here at Georgetown, and I'll be your instructor for this course. In these first two sets of videos, the introductory videos, I'm going to try to accomplish two things. In the first video, I'm just going to go over what this class is about, what you can expect to learn, what our learning outcomes in, what questions are we trying to answer, what can you expect, and so on. In the second video recording, I'm going to give you some tips on how I think you can get the most out of this class. I've been teaching about 15 years now. I taught a number of Master in Finance, MBA, many different graduate students, and I'll just maybe reflect on some common themes that I've seen in the more successful students, and also tell you maybe some pitfalls that you can avoid so you don't have to struggle any more than necessary with the course. What is this course about. So to start off, just what this course is about. The course is largely concerned with answering two really big picture questions. So the first question is, what investments should a corporation make? And here, we're talking about investment in real assets, as opposed to investment in financial assets. So as you know, financial assets are things like stocks and bonds and derivatives and assets that just have claims on other things. Real assets are-- well, first of all, you can have tangible real assets--things like a factory or some real estate or furniture or machinery. And you can also have intangible assets, like investing in R&D to generate patents and other type of knowledge, investing in marketing to increase your brand name. So a corporation-- it's faced with different types of investment decisions it can make, and it needs to figure out what do we invest in, and what do we not invest in? And so a big part of this course is just developing the type of analytical tools to help guide a corporation in making those decisions. And actually, we'll be able to come up with a numerical answer for if we do this particular type of investment, how much value will it create for our firm? Or how-- conversely, how much value would it destroy if we went and did this? And so that's the first question. What investment should the corporation make? How do we go about analyzing that and why? The second big picture question is, how should a corporation pay for those investments? So very generally, you have three choices. You can use internal funds. You can issue shares, issue equity where you have new owners now come in and own part of the corporation, and then in exchange, they paid some money to the existing shareholders, and the firm can use that to invest. So you can use internal funds. You can issue new equity. Or, of course, you can borrow money, you can issue bonds, or you can borrow money from the bank. And so that's the second big question. How do we finance the different investments that we want to make? Now, when trying to decide the answer to these two big decisions, we have one kind of overarching goal that we're going to assume. And we're going to assume that the manager's goal, the firm's goal, is to maximize the value of the firm. So when I'm deciding what do I invest in, I'm going to invest in something if it increases firm value, and I'm not going to invest if it destroys from value. When I'm deciding how to finance things, I'm going to pick the financing vehicle that does the most to increase firm value. And I would, of course, avoid any type of financing scheme that would harm, or at least not benefit from value. And so the reason for this is that managers, executives work for shareholders. Shareholders own the firm. And so firms sometimes can have thousands, maybe even millions, of different shareholders, if you count the fact that many firms are owned through mutual funds and index funds, and those have thousands and millions of different owners. The one thing that all shareholders may have in common is that they prefer more wealth to less. So for all shareholders, if the firm becomes more valuable, they're made a little bit better off. Of course, shareholders might want to do different things with the money they get from the firm. Some people maybe are saving for college or saving to buy a home. You'd like to give to a charity. But in the end of the day, if the firm is worth more, all the shareholders are made better off. Shareholders own the firm. Manager works for their shareholders. So the manager, therefore, should operate the firm in a way that makes its owners, the shareholders, better off. So whenever we look at these two big decisions--what do I invest in, how do I finance it--we're going to be working under the assumption that our goal is to maximize the value of the firm. Something I should point out--maximizing firm value, despite what you might have heard, it doesn't mean like go out and be a pirate and do all these bad things. It does not mean seeking short-term profits at the expense of everything else. We'll talk about more in the next section on governance--what that actually means, and why it actually kind of means that you need to do things that actually benefit other people and benefit other stakeholders if you want to maximize firm value. But it does not mean maximizing short-term profits. And of course, most investments decrease short-term profits with the expectation that you'll have more profits down the road later on. So anyway, the goal is to maximize firm value, and maximizing firm value does not mean just do everything you can right now to maximize short-term profits. Just keep that in mind. So for both investment and financing decisions, our two big decisions, we're going to try to choose the path that maximizes the value for the firm. And that's the basic goal of the class. So the goal of the class is you have your financial analyst, 
you're an executive, you're operating a firm, you want to maximize firm value--let's develop some tools so that when different decisions come up, we can make those decisions in a way such that value is maximized. So a bit on the background on some of the tools that we're going to develop-- like, what are the origins of the financial analyses that we're going to teach you? So the analytical tools that we are going to study-- they're used in practice, but they weren't developed by practitioners. So we didn't come about these tools by professors kind of observing what people do in practice, and then kind of writing books about it. The tools actually were developed in academic papers, where you had academic financial economists attempting to provide analytical solutions to different types of economic problems that firms face. So some examples of these questions that academic economists were trying to answer--and in some cases, people won Nobel prizes for coming up with solutions to this--but how much debt should a firm have? So again, as I said, one of the big questions we're going to talk about is, how should the firm finance itself. Well, does that even matter? Does it matter if you use debt or equity? And if it does matter, is there some optimal amount of debt you should have? How should a firm measure its opportunity cost? So for example, if a firm's trying to decide, do we go build a factory? How do we decide if that's a good idea or not? And the basic framework we're going to have is that we're going to figure out how much extra value the factory would create for the firm. And then we're going to compare that to if the shareholders instead took that capital you're going to spend on the factory, and they went and invested it somewhere else, how much value would be created by that investment? We're also going to look at-- so, let's say, a firm really doesn't have any good investment opportunities, and it wants to return some of its profits to the shareholder, return some of the cash to the shareholders. Does it matter if it pays a cash dividend or repurchases the shares? So those are the two main ways that a firm can return monies to its shareholders. So those are some of the examples of questions that we're going to answer. We're going to develop tools to answer these questions. And as I said, the origins of these tools actually come from academic papers. But they are used in the real world. And, of course, in the live session of this class, we're going to do actual real-world case studies, where we kind of apply these tools in practice.

Common themes

Now, what are some common themes to the tools that are, I think, good to pay attention to? And you're already familiar with them based on, I think, the last finance class that you took. But here, we're going to build them up and apply them in corporate finance settings. But financial analyses almost always involves three things--estimating a cash flow, estimating a discount rate, and then coming up with a present value. So if you can estimate cash flows, if you can estimate a discount rate or cost of capital, and then you can take those two things and compute a present value of those cash flows, you can evaluate projects with any kind of project in a firm, and you can value a firm in its entirety. Actually, with just those three things, you can pretty much answer both of those big questions--what should the firm invest in? How should the firm finance those investments? If you can figure out what those three things are--you know how to estimate cash flow, you know to estimate present value, you know how to estimate the discount rate, you can really answer any of those questions in all kinds of different settings. So it's really just taking those three ingredients, and just redeploying them in different ways, and you can answer almost any question that we're going to pose in corporate finance. And so cash flow-- you know some of this from accounting, but we're going to explicitly here also talk about how we're going to measure cash flow. But, of course, cash flow is driven by profit, but it's not the same thing as profit. Discount rates are how we reflect opportunity cost. A discount rate reflects if someone were to invest outside of the firm, what's the rate of return they would expect to get on their investment? And then we can use that to measure how well investments are working inside of the firm. And then, of course, present value--basic building block of finance. A dollar in the future is worth less than a dollar today. So whenever we're going to do a project or value a firm, we're forecasting future cash flows, and then we're using a discount rate to bring them back to come up with the present value today. Industry features Now, in addition to these analytical tools, we're also going to study some features of industry. And so these are--I guess here we're not kind of discounting cash flows when we do this. We're just kind of learning industry features that are relevant for the things that we're trying to understand in the course. And so in examples, we're going to do a big section on mergers and acquisitions. Some of that will be analytical, like how do you value a target and a takeover? How can the firm decide if it's a good idea to acquire another firm or not? But we'll also just learn some, I guess, industry things about mergers and acquisitions. For example, something called the Revlon Standard, which comes out of a Delaware court ruling, which I guess governs how a board of director needs to act when they're selling a firm. So we'll learn what that is and why it's important. We're going to do a section on corporate restructuring, and we're going to learn what's a leveraged buyout? What's a corporate divestiture? Why might firms do those, and so on.

Course topics

So very generally, the class has six broad topics. The first topic is corporate governance, where we revisit, again, the goal of the firm. I've already mentioned what that is. It's to maximize firm value. And then we're going to look at these things called agency problems that kind of crop up. And so just very briefly--what's an agency problem? So what we have is if the principals, the owners of the firms or shareholders, that they typically don't operate the firm. The firm is operated by managers and executives, and they have their own incentives. So sometimes managers and executives, rather than want to maximize firm value, maybe they want to do something else that serves their own interest. And corporate governance is really just a set of mechanisms that tries to align what managers and executives might want to do with what shareholders want. So how do we--what types of mechanisms are going to encourage managers and executives to make decisions that will maximize firm value and benefit shareholders? Then we move on to capital structure, and that's simply--I mean, the simple question there is, does it matter how much debt a firm has? Does it matter a firm's leverage? That's another word for saying how much debt does a firm have in its capital structure, where capital structure refers to financing. Do I finance myself with equity or debt? So we'll just ask, does it matter how much leverage a firm has? And if it does matter, is there an optimal amount, and how do we figure that out? Then we're going to talk about cost of capital. You've done some of this with the CAPM. You learned about the Capital Asset Pricing Model. That's a way to measure cost of equity capital. We're also going to talk about how to measure cost of debt, and then put them together to come up with a weighted average cost of capital. So when we want to value a firm or value different projects that a firm might do, we can use that as the discount rate. Then we're going to move on to capital budgeting and payout policy. And so capital budgeting is just deciding what to invest in. How do we measure if an investment creates value for the firm or destroys value? And then payout policy--what that looks at is if we've decided we don't want to invest, but we have these surplus funds, what do we do with them? Do we pay them out as a dividend, or do we repurchase shares? Those are the two main ways that you can return money to your shareholders. And we're going to ask, does it matter how you do it? And if so, why? Then we'll move on to the section on mergers and acquisitions. We'll talk a little bit how to value a takeover target. We'll talk about deal appraisal--how does the firm decide if the deal is good or not? We'll also talk about hostile takeovers and takeover defenses. And then the last thing, what we'll close out the class on, is corporate restructuring. There we'll learn about leveraged buyouts, leveraged restructurings, what is private equity, what do we mean by divestitures, how does bankruptcy in Chapter 11 work, and so on. So those are the topics that the course will cover. And they're all somewhat interrelated with each other, too. So it's important, too, that you do the course in order, and don't kind of just skip around. And what I mean by that is so when we do cost of capital, a lot of what you're going to learn on cost of capital rests on some of the things we've learned in capital structure. And then when we go on to capital budgeting in mergers and acquisitions, if you don't understand how to measure opportunity cost, you won't be able to do things in those sections. So do the course in its order. Watch the videos in their order. And before you-- if there's something you don't understand, watch the video again, or maybe even kind of just read in the book a little bit, and make sure that you're kind of firm on things before you go on to the next topic.